SEC Proposes New Rule That Would Require Broker-Dealers to Act in Best Interest of Retail Customers
On April 18, 2018 the SEC proposed a new rule under the Securities Exchange Act of 1934—“Regulation Best Interest” (Reg. BI)—that would establish a “Best Interest” standard of conduct for broker-dealers when making securities transaction recommendations to retail customers.
Reg. BI would require broker-dealers, including natural persons associated with a broker-dealer, at or before the time of recommending any securities transaction or investment strategy involving securities to a “ retail customer ”1 to do so without placing the financial or other interest of the broker-dealer ahead of the interest of the retail customer. Under Reg. BI, this standard would be achieved if the following three obligations are met:
1. Disclosure Obligation. The broker-dealer or associated person, before or at the time of making a securities recommendation, would be required to reasonably disclose in writing to the retail customer
(a) the material facts relating to the scope and terms of the relationship, and (b) all material conflicts of interest 2 associated with the recommendation.
2. Care Obligation. The broker-dealer or associated person would be required to exercise reasonable diligence, care, skill and prudence to:
(a) understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
(b) have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile 3 and the potential risks and rewards associated with the recommendation; and
(c) have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.
3. Conflict of Interest Obligation. The broker-dealer would be required to establish, maintain and enforce written policies and procedures reasonably designed to:
(a) identify, and disclose or eliminate, all material conflicts of interest that are associated with recommendations to retail customers; and
(b) identify, disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.
“Best Interest” is not defined in the proposed rule text. Compliance with the Best Interest requirement would be determined by the facts and circumstances of the particular recommendation, the particular retail customer and the application of the three obligations discussed above. Compliance would be determined only at the time a recommendation is made, and the Best Interest requirement would not continue into the future or create any requirement to monitor the suitability of the recommendation or reject a retail customer’s final investment decision. Furthermore, scienter would not be required to establish violation of the Best Interest requirement.
In the Reg. BI proposing release, the SEC provided the following additional information regarding compliance with the three obligations under the Best Interest requirement:
1. Disclosure Obligation Compliance. Under the proposed rule, a broker-dealer would need to provide sufficient information to enable a retail customer to make an informed decision with regard to a recommendation. Such disclosure must be true and may not omit any material facts necessary to make the required disclosures not misleading. Disclosure should be concise, clear and understandable. No specific form or manner of written disclosure is being proposed. Investors should receive information early enough in the process to give them adequate time to consider the information received and make informed investment decisions, but not so early that the disclosure fails to provide meaningful information. Certain disclosures may be standardized, but certain recommendations may require tailored or additional disclosure. In conjunction with the proposed Best Interest rule, the SEC also proposed a rule that would require broker-dealers and investment advisers to provide to retail investors a short customer or client relationship summary using Form CRS. 4 However, use of Form CRS alone would not necessarily satisfy a broker-dealer’s disclosure obligations under the proposed Best Interest rule.
2. Care Obligation Compliance. Under the proposed rule, a broker-dealer should generally make a reasonable effort to ascertain information regarding an existing customer’s investment profile, and it must consider whether it has sufficient information, prior to the making of a recommendation. A broker- dealer would not be required to analyze all possible securities or investment strategies to find the single best investment option for the retail customer. However, broker-dealers should generally consider reasonably available alternatives as part of having a reasonable basis for making the recommendation. While the cost associated with a recommended investment option generally would be an important factor, other factors (e.g., the product’s or strategy’s investment objectives, characteristics, liquidity, risks and potential benefits, volatility, and likely performance in a variety of market and economic conditions) should be considered in determining whether a recommendation is in the best interest of a retail customer. A broker-dealer may not simply recommend the least expensive option without further analysis of other relevant factors and the retail customer’s investment profile. However, a broker-dealer would need to have a justification, based on other factors, for recommending a more expensive security or investment strategy over another reasonably available alternative. Furthermore, violation of the care obligation would not require fraud or deceit and therefore compliance could not be achieved merely through disclosure.
3. Conflict of Interest Obligation Compliance. In the proposing release, the SEC stated that reasonably designed policies and procedures to identify material conflicts of interest generally should:
(a) define such material conflicts in a manner that is relevant to a broker-dealer’s business and in a way that enables employees to understand and identify conflicts of interest;
(b) establish a structure for identifying the types of material conflicts that the broker-dealer may face, including as the business evolves, and whether such conflicts arise from financial incentives;
(c) provide for an ongoing (e.g., based on changes in the broker-dealer’s business) and regular, periodic (e.g., annual) review for the identification of conflicts associated with the broker-dealer’s business; and
(d) establish training procedures regarding the broker-dealer’s material conflicts of interest, how to identify such material conflicts of interest, as well as defining employees’ roles and responsibilities with respect to identifying such material conflicts of interest.
Reg. BI would give broker-dealers flexibility to develop and tailor reasonably designed policies and procedures based on each firm’s circumstances, which policies and procedures would be reviewed and modified as needed over time. The SEC also provided a list of concerns that broker-dealers should consider addressing in their conflict mitigation procedures, including the following:
• avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;
• minimizing compensation incentives for employees to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis;
• eliminating compensation incentives within comparable product lines;
• implementing supervisory procedures to monitor recommendations that are near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products or transactions in a principal capacity; or involve the rollover or transfer of assets from one type of account to another or from one product class to another;
• adjusting compensation for registered representatives who fail to adequately manage conflicts of interest; and
• limiting the types of retail customers to whom a product, transaction or strategy may be recommended.
In the proposing release, the SEC clarified that the following practices, which generally involve conflicts of interest, would not be per se prohibited by or compliant with the Best Interest requirement:
• charging commissions or other transaction-based fees;
• receiving or providing differential compensation based on the product sold;
• receiving third-party compensation;
• recommending proprietary products, products of affiliates or a limited range of products;
• recommending a security underwritten by the broker-dealer or a broker-dealer affiliate, including initial public offerings (IPOs);
• recommending a transaction to be executed in a principal capacity;
• recommending complex products; and
• allocating trades and research, including allocating investment opportunities (e.g., IPO allocations or proprietary research or advice) among different types of customers and between retail customers and the broker-dealer’s own account.
The public comment period on Reg. BI will be open until August 7, 2018.
The proposing release for Reg. BI is available at: https://www.sec.gov/rules/proposed/2018/34-83062.pdf
1Reg. BI would define a “retail customer” as “a person, or the legal representative of such person, who: (1) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer or a natural person who is an associated person of a broker or dealer, and (2) uses the recommendation primarily for personal, family, or household purposes.”
2The SEC proposed to interpret a “material conflict of interest” as one “that a reasonable person would expect might incline a broker-dealer—consciously or unconsciously—to make a recommendation that is not disinterested.”
3 Under the proposal, “investment profile” would include, without limitation, age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and other information
4 See the summary under “SEC Proposes New Disclosure Requirement for Financial Professionals” below